Commentary on Economics, Information and Human Action

Apple’s jack and incumbent vertical market power

Apple’s controversial decision to remove the universal 3.5mm audio jack from its just-released iPhone 7 has several economic dimensions. All of them are a consequence of Apple’s proprietary architecture (colloquially known as “Steve’s walled garden”) and the extent to which Apple is trying to/able to exercise incumbent vertical market power. How much market power does Apple have?

With the iPhone 7 the only external wired interface now will be through the proprietary Lightning port; Apple has a patent on the Lightning interface and charges a royalty to third-party device manufacturers for its use. If you are a headphone manufacturer, you now have to pay a royalty to make Lightning headphones, and those headphones can’t be used in other devices without a Lightning/3.5mm jack adapter. Similarly, standard headphones won’t work with the iPhone 7 without a 3.5mm jack/Lightning adapter, the manufacturer of which will have to pay Apple a royalty. That also means that consumers who don’t want to buy new headphones will still have to buy an adapter.

What we have here, friends, is a failure of interoperability. This is not Apple’s first interoperability failure; in the move from FireWire 1.0 to FireWire 2.0 to Lightning, Apple demonstrates deliberate disinterest in interoperable device interfaces. It’s their market power that enables them to do so. They typically make a technical argument (faster, more streamlined, better for the user!), and while technical features provide some justification, it’s no coincidence that these failures of interoperability impose costs on their competitors in downstream related markets.

Now this failure of interoperability extends to encompass a new interface, the audio interface. The technical aspects of this move are that now the iPhone 7 will be water resistant, fit a larger capacity battery in a given space, and have more sophisticated camera technology. Benefits, to be sure, but benefits that come at a cost borne largely by Apple’s competitors. One related downstream market where this exertion of incumbent vertical market power will impose costs on competitors is the headphone market:

For many, Apple’s design decision with the iPhone 7 is alarming because it effectively abandons a universal, simple, reliable and durable technology for an entirely proprietary alternative. If you’re a headphone manufacturer who wants to make Lightning-based headphones, you’ll have to pay Apple for the privilege. If you own a pair of Lightning-based headphones, the only device in the world that can make use of them is the iPhone 7, unless, of course, you want to carry around an adapter with you everywhere you go.

At the margin this makes a consumer more likely to use the stock Lightning headphones that come with the iPhone, rather than purchasing headphones with different features that the consumer may value. It also makes consumers more likely to purchase Apple’s new wireless AirPod headphones at $159, although the sound quality isn’t that great and the real feature seems to be a superior microphone for talking to Siri. That’s the ability to exercise incumbent vertical market power, and it harms Apple’s competitors and Apple’s customers who aren’t fully invested in Apple’s proprietary architecture, in Steve’s walled garden. However, it’s also true that the AirPods can be used as standard headsets operating on the open Bluetooth standard, and that other wireless headphones will work, but not integrate with Siri as seamlessly.

This architectural choice affects a second, and more futuristically interesting, downstream market into which Apple is integrated vertically: payment systems.

While the coverage of this move has largely focused on the company’s new wireless headphones, there may be another reason Apple chose to remove the headphone jack: third-party payment systems like Square, Intuit, and PayPal will no longer be able to compete with Apple Pay on Apple product lines.

Each of the aforementioned companies relies heavily on an attachment device that hooks into the 3.5mm headphone jack. The attachment allows businesses to swipe consumer credit or debit cards when they make a purchase.

Apple Pay, conversely, allows users to pay for goods and services with just a touch of the iPhone. Essentially, Apple Pay makes physical cards obsolete. If cards are obsolete, Apple has a monopoly on the growing instant-pay market. Eliminating the 3.5mm jack could be the first step in ensuring that debit and credit cards become useless in the marketplace, opening the doors to a future cashless society.

Apple Pay competes with other mobile payment processing platforms that enable small vendors to accept credit card payments (e.g., Square, PayPal). If it’s more costly for those vendors to accept Square and PayPal because they don’t have a jack into which to plug the card reader, then at the margin they are more likely to accept ApplePay and consumers are more likely to set up and use ApplePay (and Android Pay, for that matter, which dilutes the market power in this market somewhat).

Of course, Square and PayPal can develop Lightning-based card readers. The real test of market power would come if they did so and Apple refused to license them to use Lightning. That won’t happen, though:

But now that new versions of the iPhone won’t have a headphone jack, how will that affect Square and these other payment processors?

Not much, actually. Included in every iPhone 7 purchase will be an adapter that can be inserted into the Lightning port, a connectivity option previously reserved for charging and syncing data. With the iPhone 7 and iPhone 7 Pro, owners will be able to use this connectivity port (with the adapter) to plug in anything that would plug into a standard headphone jack. Square users could simply use that dongle for the foreseeable future.

Square (SQ-0.80%) has also expanded its payment processing methods beyond just the tiny white dongle for the headphone jack. The San Francisco-based company also hawks an iPad register, called Square Stand, which costs $99 and doesn’t use the headphone jack. In 2015, Square debuted a new contactless method, which lets consumers use both Apple’s contactless mobile payments technology, Apple Pay, and Google’s payments technology, Android Pay (GOOG0.54%). That new reader was also integrated for chip-enabled cards. Instead of using the headphone jack, this reader uses Bluetooth technology to connect a merchant’s phone with the credit card reader.

I think this illustrates that there is a limit to Apple’s ability to exercise incumbent vertical market power in these very fluid and dynamic markets. While Apple may seem able to exercise market power in the physical card-processing payment market, the payment market is already evolving into a wireless and contactless one.

So Steve’s walled garden has windows and doors, and its nature is ever-changing, as is the world in which it competes. This is the Schumpeterian point about the dynamism of competition.

5 thoughts on “Apple’s jack and incumbent vertical market power”

My Moto G costs 1/3rd of what an Apple costs. It uses Android, and does everything an i phone can do except demonstrate that I like to overpay to eat lunch with the cool kids.

My son who was a complete and utter Apple fanboi, is so pissed off at apple for the headphone manuver, that he will consider a non-apple phone, once he finsihes paying off his apple 6 in about 3 years.

Apple is trying to move the industry towards a fully wireless future via Bluetooth, not to drive accessory makers to use the Lightning connector. They even include an adapter to ease the transition for those who already have traditional headphones. The AirPods may use a proprietary connection, but they’re cross-compatible with traditional Bluetooth devices, as are iPhones with traditional Bluetooth accessories. The AirPods exist mainly as a reference design and to push what’s possible with wireless accessories.

What this article should’ve been about is Apple using device maker position to leverage its position in accessories. Unless Apple licenses the W1 chip in the AirPods, the AirPods themselves will provide a far superior pairing and transitioning experience compared to regular Bluetooth headphones because they were designed together with the iPhone.

The whole thing about payments equally doesn’t make sense. The author seems to be confusing different technologies and products.

There are two products/services at play here—payment verification and payment terminals. Apple Pay is a payment verification system that’s built on top of payment processors (Visa, MasterCard, Amex, etc.) and traditional debit/credit cards and their issuing banks. Square/Paypal/etc. dongles are payment terminals, which accept cards issued by payment processors. There is literally no competition here and neither are replacements for the other. One cannot receive card payments without using a separate dongle, just as one cannot pay for something using a Square reader.

No it doesn’t. A small vendor cannot receive payments with only Apple Pay.

To quote, from Apple’s support site:

“To accept Apple Pay in your store, you need to have a contactless payment-capable point of sale terminal. Contact your payment provider so they can set up your terminal, and tell them you would like to accept Apple Pay. To learn more, contact merchant support.”

Furthermore, Square is moving away from the small headphone jack-powered reader to a full Bluetooth-connected terminal capable of reading cards with the EMV chip, which is becoming a standard everywhere. This terminal is also capable of accepting Apple Pay, which the original headphone jack terminal does not.

Ergo, the two products not only completely do not compete with each other, but are complementary goods.

Peter, thank you for adding the details about the evolution of the wireless/contactless payment platform. Had you read the end of my post more carefully you would have found that I did indeed make that point, although not with the useful details you provided. Rather, my main objective was to explore the implications of this move for various markets, not to go in depth on platform competition in payment systems.

Apple Pay competes with other mobile payment processing platforms that enable small vendors to accept credit card payments (e.g., Square, PayPal). If it’s more costly for those vendors to accept Square and PayPal because they don’t have a jack into which to plug the card reader, then at the margin they are more likely to accept ApplePay and consumers are more likely to set up and use ApplePay (and Android Pay, for that matter, which dilutes the market power in this market somewhat).

You might want to just strike that, as Peter points out.

1. Sort of cut out Square and PayPal readers, but not really.
2. Don’t grab their customers because you don’t offer a competing product.
3. Profit?

The intro image and your paragraph(s) talking about it, they’re just not tenable.

Apple doesn’t, to my knowledge, sell any device that lets you take people’s money using a phone (or rather, they sell Square and PayPal and other devices in their store – but they don’t have any products I can find that take payments that are Apple branded).

If they’re trying to eat Square’s lunch they’re doing a horrible job of it, by not competing in Square’s market at all, and selling Square’s products in their store.